What it takes to achieve a profitable small business exit

Selling a small business comes with a range of challenges, particularly for service-based businesses. Leigh Adams, Special Counsel at Owen Hodge Lawyers explains some of the main barriers to a profitable small business exit and his advice to overcome them.

Here’s a very common scenario. A business has been running successfully for several years. Eventually, due to personal or other reasons, the owner decides to exit – but they don’t have a plan in place to exit successfully – or profitably.

The peculiarities of our laws present major challenges to owners of small to medium-sized businesses (SMEs) wanting to sell them. Can a profitable exit be engineered?

Common barriers to a profitable small business exit

Here are some of the barriers to a profitable sale we commonly see small business owners face when they choose to exit without a plan in place – and how to overcome them.

Personal goodwill

Goodwill is an intangible asset of the business which is necessary for the business to continue operation. For consultancy businesses or businesses built around a person rather than a brand, it can be very difficult to ascribe value to personal goodwill.

This is one of the major difficulties for any small business, particularly when the business provides services rather than goods.

Merging a small business can work, but if the prospective vendor is essentially a ‘one-man band’, then we advise against anticipating a windfall. The personal nature of many small businesses can make it very difficult to sell.

Referral networks

Any merger of a small business will see a sole owner walk out with all of his or her contacts, unless there’s an agreement that says something to the contrary.

If the rainmaker of the small business is getting and keeping the clients because they have a range of referrers who are happy to continue referring to them, how do you move that to the new business? Even with transition arrangements in place, it can be very difficult – particularly where many referral bases have aged with the vendor.

Senior employees

There are particular complexities that accompany the departure of an employee who is as qualified as the owner or rainmaker from the former business.

For example, if the person in question brings in contacts or referrals, there may be questions around the value of those contacts and how the senior employee should subsequently be compensated.

The solution for successful exits

The issue of personal goodwill is a challenge for anyone who is the sole owner of a business, or who only has one or two other co-owners. However, there are a number of options available. One is a sale to a senior employee or to several of them. Another is a merger.

But timing is very important and the timeframe will impact on strategies and options available. Generally, the longer the business operator has thought about the issue, the better the exit works.

Five years is generally the minimum timeframe necessary for any small or medium-sized business to successfully implement a succession plan. Personal goodwill can usually be realised if such a timeframe is applied.

Employee succession planning

Many successful business operators see the benefit of recruiting a senior employee who has the skills to lead the business and a desire to become an owner of it.

They also recruit some talent underneath the senior employee to give them options, in the event that the senior employee does not work out for any reason.

The best succession plans include arrangements for that senior employee. The plan should help develop their capabilities and transition the goodwill to that person over time.

Developing a transition document

Critical to the success of the desired outcome is the clear exposition of milestones to be achieved along the way. Moreover, the best plans transition not only contacts but also referral networks, and they include restrictive covenants.

The restrictive covenants acknowledge that transitioning personal goodwill is a risk, and the enterprise must be able to protect its income in the event of a falling out. The client base and the staff must be protected at all costs.

A 12-month restraint preventing the senior employee from canvassing or acting for clients out of the business is a ‘must-have’ provision.

What if the senior employee turns out to be a bad leader? This is one of the many reasons why the succession agreement must be in writing and provide for the arrangement to be terminated by either party on the occurrence of nominated trigger events. The succession provisions should be able to be cancelled without necessarily having to terminate the senior employee’s employment.

Undertaking a merger

Many of our clients have found that the merger of their business has borne fruit on many fronts. They enjoyed an enhanced quality in terms of their own business life and that of their staff.

They have said that they get much more out of life in a larger partnership or company. They enjoy the economies of scale. Merging a small business with another business gives many more options than those available to the vendor on its own.

Adding the merger option to a succession plan is not difficult. Time is the key consideration, and five years appears to be the minimum period one needs to successfully implement a merger.

That gives time to look for a business with similar values and culture, and that creates an opportunity for both the vendor and the purchaser.

Getting ready for sale

Preparing for a sale or merger is a process. The vendor’s profitability, its staff and its management need to present well.

Transitioning the personal goodwill is key. If the revenue streams cannot be transferred, then there’s nothing there to buy. We have never seen a successful small business sale without proper legal contracts binding purchasers to legally enforceable obligations. There is just no way you can value a revenue stream that is dependent on personal goodwill and the vendor ‘doing the right thing’.

In this regard, many clients confuse the concept of trust with the concept of communication. Trust is the foundation of any business dealing, but a fully-vetted contract prepared by a lawyer will communicate all aspects of the transaction. All bases will (or should) be accounted for. From the transparency that such a document brings comes confidence, and the document thereby enhances the relationship between the parties.

The legal contract should provide a clear pathway to transition, referral relationships and personal goodwill to the purchaser.

Looked at this way, a vendor does have something to sell. Many vendors can identify where the market is and tailor their assets to appeal to that market.

Where a small business merges with another business, the feedback we receive is that where a plan is in place to transition the goodwill, most of it does end up going over.

Shared ethics and values are critical to a successful merger or sale. Nevertheless, finding a successor interested in, equipped for and willing to take on the role in an established business is challenging.

Personal equity versus brand equity

The traditional approach to selling is one dimensional. A business whose goodwill is derived from personal equity is much harder than if it is based on the brand.

Brand equity is typically grounded in established businesses which have some history behind them. Brand equity also is more likely to reside in the business’s name if it didn’t include the names of the principals or founders.

Creative ways to structure the succession include a three-to-five year earn out period. While this can be nerve-wracking and unpalatable for the vendor, if structured correctly, it can provide much more to the vendor than a short-term transaction can provide.

The succession plans that work best are those developed by businesses which work out who their logical, interested buyers are and then get their plan together, prepare an information memorandum and their pitch, and then action the plan.

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